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An important decision in the design of macroeconomic policies in any country is the choice of currency and monetary regime. Not surprisingly, there is an enormous literature on currency and monetary regimes. This chapter sets out a policy menu for East Timor based on this literature, constructed in a way that suits the country’s characteristics and needs. There are two basic decisions to be made in choosing a currency and monetary regime. The first is whether to have a fixed or a flexible exchange rate. The decision to fix or float depends on weighing the advantages of one against the other, and assessing which works in practice. The second decision concerns the detail of the arrangements. The chapter is structured in the following way. The following section looks at the first decision: whether to fix or to float the exchange rate, and what this means for monetary policy. The third section assesses different types of fixed exchange rate regimes, namely the standard peg, currency board and ‘dollarization ’. The fourth section looks at which countries would be suitable pegging partners for East Timor. The chapter concludes by offering an assessment. FIX OR FLOAT? The first decision in selecting a currency and monetary regime is whether to fix or to float the currency. For a small economy like East Timor, there are two main issues to consider in making this choice. Which Regime Is More Stabilizing? The first is to assess the relative merits of having a fixed or flexible exchange 39 2 Currency and Monetary Arrangements for East Timor Gordon de Brouwer* East Timor/final 29/7/01 6:20 PM Page 39 rate. This decision ultimately turns on whether an independent exchange rate provides a country with a means to stabilize its economy as the external economic circumstances it faces change. If being able to change the exchange rate helps stabilize the economy, then having a more flexible regime is, in principle, helpful and preferable.1 The exchange rate is a relative price – the value of a country’s currency relative to that of another. As circumstances change, it may be appropriate that these changes are reflected in the exchange rate. There are two types of ‘circumstances ’ that warrant consideration. Changing Economic Circumstances Changes in a country’s external economic environment can have implications for the exchange rate. For example, if the prices of a country’s exports fall substantially , then the country suffers a fall in export income and GDP. If the exchange rate depreciates in response to this ‘shock’, then the value of exports does not fall by as much in terms of local currency, and export income and GDP are stabilized. In principle, this is relevant to East Timor because its export base is concentrated in a few commodities – coffee, oil, sandalwood and marble – most of which have volatile prices. If policy-makers want to stabilize export income, then they would need to either depreciate the currency when commodity prices fall, or fix to a currency which also depreciates when commodity prices fall. While this suggests that some flexibility in the currency regime may be helpful, there are two serious obstacles to a country like East Timor being able to adopt an independent currency in practice. The first is that it is too small to be able to rely on the foreign exchange market to set the exchange rate. A freely floating exchange rate is not a viable option for a very small country because its foreign exchange market lacks liquidity , making the currency vulnerable to sharp erratic movements (de Brouwer 2000). This means that a floating exchange rate would need to be highly managed , which leads to the second obstacle. Managing a floating exchange rate is challenging. It requires a large number of staff with substantial expertise, as well as a clear policy framework, sufficiently developed financial markets and no political interference. East Timor has scarce staff resources to support the administration of any currency and monetary regime. It has a very small population of about 800,000 people, and its labour force is estimated at less than half that, about 340,000, most of whom are not well educated. Even with foreign aid and future oil revenue, it will have at best only modest financial resources to support an administration. Changing Political Circumstances The second set of circumstances that can affect the exchange rate is political 40 Gordon de Brouwer East Timor/final 29/7/01 6:20 PM Page 40 [18.118.184...

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